Higher Order Thinking Skills Questions - Determination of Income and Employment -

Q.1 Why can the value of MPC be not greater than 1?
 Ans. MPC = ΔC/ΔY. A change in consumption (ΔC) cannot exceed the change in income (ΔY), so MPC cannot be greater than 1. If MPC were > 1, households would increase consumption by more than the rise in their income, leaving no room for saving of the additional income and implying unsustainable borrowing. For example, if ΔY = Rs.100 and MPC = 0.8 then ΔC = Rs.80; MPC > 1 would mean ΔC > Rs.100 which is not feasible under normal circumstances. Therefore MPC normally lies between 0 and 1.
Q.2 Does an excess of AD over AS always imply a situation of inflationary gap?
 Ans. No. An inflationary gap arises only when aggregate demand (AD) exceeds aggregate supply (AS) at the full-employment level of output. If AD > AS while the economy is below full employment, the excess demand tends to raise output and employment rather than prices, narrowing the output gap instead of producing inflation.
Q.3 What happens if AD>AS prior to full employment level of employment?
 Ans. This is a state of disequilibrium. When AD > AS before full employment: producers meet the extra demand from existing stocks, so desired inventories fall. Firms then increase production to replenish stocks and meet demand. Higher production raises incomes and employment, which further increases AD via the multiplier process. This adjustment continues until AD and AS are brought into equilibrium or until the economy reaches full employment.
Q.4 In poor countries like India , people spend a high percentage of their income so that
 APC and MPC are high . Yet , value of multiplier is low . Why?
 Ans. The multiplier process requires spare production capacity so that an increase in demand leads to a proportionate rise in output and income. In many poor economies there is limited production capacity and frequent supply bottlenecks. As a result, when consumption rises, much of the effect shows up as higher prices (inflation) or increased imports rather than higher domestic output. These leakages and supply constraints weaken the multiplier even though APC and MPC are high.
Q.5 Show a point on the consumption curve at which APC= 1.
 Ans. Let the consumption function be C = a + bY, where a is autonomous consumption and b (= MPC) is the slope. Then average propensity to consume is APC = C/Y = a/Y + b. For APC = 1:
a/Y + b = 1 → a/Y = 1 - b → Y = a/(1 - b).
Therefore APC = 1 at the income level Y = a/(1 - b). Graphically, this is the point where the consumption curve meets the 45° line (C = Y), that is, where consumption equals income.